Sobering Proposed Tax Changes
On July 18, 2017, the Federal government released its consultation paper on proposed tax changes for their perceived abuses of the tax system by private corporations. The proposals are sobering in that we have not seen these kinds of changes to the tax system in a long time. If the changes are implemented as proposed, life will be different for private corporations and their owners.
Our review of the proposals are noted in this summary and are concentrated on the targeted tax planning strategies which have been around for a long time and commonly used by owners of private corporations.
Tax Strategy – Sprinkling income using private corporations
Income sprinkling arrangements provide owners of private corporations the ability to distribute dividends to members of their families that are taxed at lower tax rates than the owners. Presently, if an owner has in place a trust or other arrangement, they may be able to pay a dividend to a family member that is taxed at a lower rate. However, they have been prevented from paying such a dividend to a minor because of what is referred to as the Tax on Split Income (TOSI) rules. Currently, if income is shifted to a minor, then that income is taxed at the highest tax rate regardless of the tax rate of the minor.
Included in the proposal, are measures to extend the TOSI so that it applies to certain adult specified individuals. As such if an adult specified individual receives split income, then the income could be subject to the highest tax rate (In Ontario, 53.5% for salary, 45.3% for ineligible dividend and 39.3% for eligible dividend) if the income shifted to that individual would exceed what an arm’s length party would have agreed to pay to the adult specified individual, considering their labour and capital contributions (“reasonableness test”). This new reasonableness test essentially would look at the involvement of the adult specified individuals in the business as well as their capital contributed by way of contributed assets or assumption of risk in supporting the business. The reasonableness test as proposed will be more stringent for adult family members between the ages of 18 and 24.
Income shifted, by way of dividends, with spouses and/or adult children, who are not active in the business, would be caught by the new proposed TOSI rules. The rules are proposed to be effective after 2017.
Tax Strategy – Multiplication of Lifetime Capital Gains Exemption (LCGE)
Currently discretionary family trusts are being used in certain tax planning strategies to take advantage of or to multiply the LCGE. This allows individuals who have not invested in or contributed to a business to utilize and multiply the exemption. With the LCGE an individual can shelter a capital gain of approximately $835,000 for 2017 and not pay income taxes of $223,000 (for those at the highest tax bracket).
The Government is proposing to disqualify individuals for claiming the LCGE on capital gains realized or accrued before they are 18 years of age. Also the Government is proposing that the LCGE not be available if the capital gain is included in an individual’s split income based on the reasonableness tests proposed in the extension of TOSI rules noted above. In addition, it is proposed, that any gains that accrued while the shares are held by a trust would no longer be eligible for the LCGE unless specific exemptions are met. The proposed measures apply to dispositions after 2017. However, transitional relief is being proposed that will be available on qualifying shares which will allow affected individuals to crystalize any accrued gains.
Tax Strategy – Passive Investments held in a private corporation
Corporate tax rates are generally much lower than personal tax rates. In Ontario, the corporate tax rate is 15% for the first $500,000 of active income and 26.5% thereafter. In Ontario, the personal tax rate is as high as 53.5% if you are in the top-tax bracket. The result is that if corporations are able to retain after-tax earnings for an extended period of time, then according to the government the substantial tax deferral is unintended and un fair. The Government believes the deferral is an unintended result of low corporate taxes and it essentially allows for too much passive investments in corporations.
Accordingly, the Government is considering, changes to neutralize their perceived unintended tax advantage, such as eliminating “refundable taxes” on investment income and restricting a private corporation from paying tax-free “capital dividends” to the extent the capital gains were realized from the use of active business income.
The Government will review various alternatives following these consultations and will provide time before the new proposal becomes effective.
Tax Strategy – Converting regular income into capital gains
The tax rate on capital gains is 50 % of the tax on regular income as such tax on capital gains is substantially lower than the taxes on a salary or dividends. This provides incentives for the taxpayers to enter into transactions among related parties to convert what would otherwise be a salary or dividend into a capital gain.
Current anti-avoidance rules noted in section 84.1 of the Income Tax Act ensure that a corporate distribution is taxed as a salary or dividend when an individual sells shares of a corporation to a non-arm’s length corporation. However, this rule is limited to situations where the LCGE is being claimed resulting in no taxes payable on capital gains triggered while providing a mechanism to strip the corporate surplus.
The proposed amendments to this section of the Act would expand the situations where 84.1 would be applicable to even those where the LCGE was not claimed and taxes on capital gains are paid. It also introduces anti-avoidance rules to target any non-arm’s length transaction that converts salary or dividend into capital gains. This “catch all” anti-stripping rule will apply to transactions on or after July 17, 2017 and is intended to prevent any types of surplus stripping to an individual by effecting the transaction at a lower capital gains tax rate.
Conclusion
These significant proposed changes to the tax system, if implemented as proposed, will significantly change tax planning for private businesses. We plan on making a submission to the Department of Finance as part of the consultation process to try to change some of their thinking. We will keep you posted.
The information in this article is of a general nature and is in summary form and may not include all the details noted in the consultation paper. Contact one of our tax professionals to discuss these matters in the context of your situation before acting upon such information.
